Index funds have become extremely popular during the past 10 years and the most popular of all are ones based on the S&P 500. As of this writing SPY, an S&P 500 index, is the most popular exchange traded index fund with $63 billion in assets. The next most popular is GLD with only $31 billion in assets. But that is only a small portion of the total amount invested in S&P 500 based index funds. Nearly every major fund company also offers one. The Vanguard S&P 500 index fund, the granddaddy of them all which started the trend on Oct 31, 1976, has $84 billion in assets.
There are basically three selling points proponents of the S&P 500 index funds use when advocating purchase. First is the low expense ratio. The Vanguard fund has an expense ratio of 0.18%. SPY has an expense ratio of 0.10%. The median expense ratio of mutual funds is about 1.5%. Second, is the tax advantage of index funds. Since these are unmanaged funds they are very tax efficient. There is very little realized year end capital gains with an S&P 500 index fund if any at all. Managed mutual funds very often have very large year end capital gains upon which taxes must be paid. Third is that 70% of all mutual funds have underperformed the S&P 500 index so it is better to just place ones money into that index fund than to invest in a managed fund.
What is not ever discussed are what the disadvantages of the S&P index funds might be. There are several that one needs to be aware of. First and perhaps formost is the fact that it is capitalization weighted. What that means to the investor is that even though one has an investment in 500 different companies, it is not an equal investment. The top 10 holdings account for 20% of the total assets of the fund. The top 50 holdings account for 48% of the assets. The other 450 the remaining 52%. One of the cornerstones of the theory of modern portfolio allocation, is the concept of rebalancing ones portfolio on a periodic basis normally annually or quarterly to increase ones return and decrease ones risk. Since the S&P 500 index is capitialization weighted, not only is it not rebalanced but one might argue that it is debalanced, if there is such a word. In other words as the price of stocks in the index rise, the index buys more of them relative to the ones that fall in price. That is the exact opposit of the concept of rebalancing. One can in fact visually see the difference to returns that rebalancing has in the past made. There is another index fund based on the S&P 500 that is equal weighted rather than capitalization weighted. It is RSP. It has not been in existance 10 years so we can not do a long term comparison. But over a 5 year period SPY has returned 0.44% and RSP has returned 2.23%. That is despite the fact that RSP has an expense ratio of 0.60% compared to an expense ratio of 0.10% for SPY.
The S&P 500 is based only on US based large company equities. It ignores foreign companies, most small capitalization companies, and investments in debt instruments. It actually does consist of a few small cap stocks, ones that are still in the index but have recently fallen on hard times. As of this posting these include Gannet, CIT, and KB Home to name a few.
Foreign equities as recently as 1970 accounted for about 30% of total world market capitalization. Currently they have risen to over 50% of total market capitalization probably closer to 60% currently. So in the past 40 years the U S equity market has declined by about 1/2 of the total world equity markets. That decline should be noted by investors. Another aspect that should be noted is that investor returns on foreign equities over the past 5 years have in many cases outpace returns of the S&P 500. 10 year comparisons can not be made because indexes of foreign equites have only recently existed. But here are a couple of comparisons. The 5 year return of the S&P 500 index is 0.44%. That of IEV based on the S&P Euro 350 index is 5.7% despite having an expense ratio of 0.60%. That of EAF based on the European, Far East, and Australian index is 5.4%. That of EEM based on an emerging market index is 16.4%.
When we compare the S&P 500 performance to that of the small cap index funds we again see a divergence in returns. For the five year period IWM based on the Russell 2000 had a return of 2.2%.
Another aspect of asset allocation that is ignored by many is that of investing in debt investments as opposed to equity investments. The classic concept is that equity investments will outperform debt investments over the long term mainly because one must expect a greater return for the greater risk of equity investments. Invariably investment professionals will advise young clients to invest most of their assets if not all in equities because even though there is a greater probability of suffering a loss over the short term over the long term equities will provide a greater return. Yet the results of portfolio allocation theory tend to somewhat refute this claim. And certainly over the last 10 years debt investments have outperformed equity investments. Almost every managed bond fund over the past 10 years has outperformed the S&P 500 index by a wide margin. Vanguard Long-term Investment Grade bond fund has yielded 8.5% annually on average since Sept 1973. The S&P 500 has returned 6.5% over the same period. Those returns are before taxes.
Another interesting comparison is that of the Vanguard Balanced Index fund to that of the S&P 500. The Balanced fund has returned 2.9% annually over the last 10 years opposed to - 0.86% for the Vanguard S&P 500 fund.